Derivatives market


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Derivatives market

  2. 2. CERTIFICATEI hereby certify that JASMEET SINGH NAGPAL of Guru Nanak Khalsa College ofTY BFM of sem v has completed the project on DERIVATIVES MARKET in theacademic year 2012- 2013 under the guidance of Professor , the informationsubmitted is true and original to the best of my knowledge.signature of coordinator signature of the principalsignature of project guide signature of external examinerCollege seal
  3. 3. DECLARATIONI JASMEET SINGH NAGPAL of TY BFM of Sem V hereby declare that I havecompleted this project on DERIVATIVES MARKET in the academic year 2012-2013.This information is true and original to the best of my knowledge.signature of student
  4. 4. INDEXCHAPTER UNITS TOPICS PG.NO1INTRODUCTION1.1CONCEPT OF DERIVATIVES1.2 ORIGIN OF FINANCIAL DERIVATIVES1.3 ECONOMIC FUNCTIONS OF A DERIVATIVE MARKET2 FUTURES2.1Definition of Futures Contract2.2: Terminologies in Futures Market2.3: TYPES OF FUTURES CONTRACT2.4: PURPOSE FOR TRADING IN FUTURES MARKET2.5: What is a stock index futures contract?2.6: Advantages of using Stock-Index Futures3 FORWARDS3.1: Definition of Forwards contract3.2 Settlement of forward contracts3.3Default Risk in Forward Contract :3.4Difference between Forward & Future Contract4OPTIONS4.1 Definition of Options4.2 Types of Options4.3Options are different from Futures4.4 Option Terminology4.5 How to start Option Trading ?
  5. 5. CHAPTER UNITS TOPICS PG.NO4.6Factors that affect the value of an option premium4.7Different pricing models for options4.8 Option Greeks4.9 Benefits of Option Trading5CONCLUSION6ANALYSIS
  6. 6. CHAPTER 1: INTRODUCTION1.1: CONCEPT OF DERIVATIVESOne of the most significant events in the securities market has been thedevelopment and the expansion of financial derivatives. The term “derivatives”is used to refer to financial instruments which derive their value from someunderlying assets. The underlying assets could be equities (shares), debt (bond,T-bills and notes), currencies and even indices of these various assets such asNifty 50 Index. Derivatives derive their name from the respective underlyingasset. A simple example of derivative is butter, which is derivative of milk.Theprice of butter depends upon price of milk, which in turn depends uponthedemand and supply of milk.The general definition of derivatives means toderive something from somethingelse.Derivatives can be traded either on a regulated exchange such as NSE oroff the exchanges i.e. directly between the different parties which is called “overthe counter” (OTC) trading. The basic purpose of derivatives is to transfer theprice risk (inherent in fluctuations of the asset prices) from one party to another.They facilitate the allocation of risk to those who are willing to take it. In sodoing, derivatives help mitigate the risk arising from the future uncertainty ofprices. For example, on October 1, 2011 a rice farmer may wish to sell hisharvest at a future date (say January 1, 2012) for a pre- determined fixed priceto eliminate the risk of changes in prices by that date. Such a transaction is anexample of a derivatives contract. The price of derivative is driven by the spotprice of rice which is “underlying”.
  7. 7. According to the Securities Contract Regulation Act, (1956) the term“derivative” includes:(i) a security derived from a debt instrument, share, loan, whether secured orunsecured, risk instrument or contract for differences or any other form ofsecurity;(ii) a contract which derives its value from the prices, or index of prices, ofunderlying security.1.2: ORIGIN OF FINANCIAL DERIVATIVESFinancial derivatives have emerged as one of the biggest markets of the worldduring the past two decades. A rapid change in technology has increased theprocessing power of computers and has made them a key vehicle forinformation processing in financial markets. Globalization of financial marketshas forced several countries to change laws and introduce innovative financialcontracts which have made it easier for the participants to undertake derivativestransactions.Early forward contracts in the US addressed merchants‟ concerns aboutensuring that there were buyers and sellers for commodities. „Credit risk‟,however remained a serious problem. To deal with this problem, a group ofChicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. Theprimary intention of the CBOT was to provide a centralized location (which
  8. 8. would be known in advance) for buyers and sellers to negotiate forwardcontracts. In 1865, the CBOT went one step further and listed the first„exchange traded” derivatives contract in the US. These contracts were called„futures contracts”. In 1919, Chicago Butter and Egg Board, a spin-off ofCBOT, was reorganized to allow futures trading. Its name was changed toChicago Mercantile Exchange (CME).The CBOT and the CME remain the two largest organized futures exchanges,indeed the two largest “financial” exchanges of any kind in the world today.The first exchange-traded financial derivatives emerged in 1970‟s due to thecollapse of fixed exchange rate system and adoption of floating exchange ratesystems. As the system broke down currency volatility became a crucialproblem for most countries. To help participants in foreign exchange marketshedge their risks under the new floating exchange rate system. Foreign currencyfutures were introduced in 1972 at the Chicago Mercantile Exchange. In 1973,the Chicago Board of Trade (CBOT) created the Chicago Board OptionsExchange (CBOE) to facilitate the trade of options on selected stocks. The firststock index futures contract wastraded at Kansas City Board of Trade. Currentlythe most popular stock index futures contract in the world is based on S&P 500index, traded on Chicago Mercantile Exchange. During the mid eighties,financial futures became the most active derivative instruments generatingvolumes many times more than the commodity futures. Index futures, futures onT-bills and Euro- Dollar futures are the three most popular futures contractstraded today
  9. 9. 1.3: ECONOMIC FUNCTIONS OF A DERIVATIVEMARKETThe following are the various functions that are performed by thederivativemarkets:Prices in an organized derivative market reflect the perception ofmarketparticipants about the future and lead the prices of underlyingto the perceivedfuture level.Derivative market helps to transfer risk from those who areexposedto it but may like to mitigate it to those who have an appetite forrisk.Derivative market has helped in increasing savings and investmentin thelong run.It would be useful to be familiar with two terminologies relating totheunderlying markets:1) Spot Market: In the context of securities, the spot market or cash marketis asecuritiesmarket in which securities are sold for cash and deliveredimmediately. Thedelivery happens after the settlement period. The NSE‟s cashmarket segment is known as the Capital Market (CM). In this market, shares ofSBI, Reliance, InfosysSegment. In this market, shares of SBI, Reliance, InfosysICICI Bank, and other public listed companies are traded. The settlement periodin this market is on a T+2 basis i.e., the buyer of the shares receives the sharestwo working days after trade date and the seller of the shares receives themoney two working days after the trade date.
  10. 10. 2) Index: Stock prices fluctuate continuosly during any given period. Prices ofsome stocks may move up while that of others may move down. In such asituation, What can we say about the stock market as a whole? Has the market moved up or has it moved down during a givenperiod? Similarly, have stocks of a particular sector moved up or down?To identify the general trend in the market or any given sector of the marketsuch as telecommunication, it is important to have a reference barometer whichcan be monitored. Market participants use various indices for this purpose. Anindex is a basket of identified stocks, and its value is computed by taking theweighted average of the prices of the constituent stocks of the index.For example consists of a group of top stocks traded in the market and itsvaluechanges as the prices of its constituent stocks change. In India, NiftyIndex is the most popular stock index and it is based on the top 50 stockstradedin the market. Just as derivatives on stocks are called stockderivatives,derivatives on indices such as Nifty are called index derivatives
  11. 11. CHAPTER 2: FUTURES2.1: Definition of Futures ContractA futures contract is an agreement between two parties to buy or sell an asset ata certain time in future at a certain price. These are basically exchange traded,standardized contracts. The exchange stands guarantee to all transactions andcounterparty risk is largely eliminated.The buyers of futures contracts are considered having a long position whereasthe sellers are considered to be having a short position. It should be noted thatthis is similar to any asset market where anybody who buys is long and the onewho sells in short. Futures contracts are available on variety of commodities,currencies, interest rates, stock and other tradable assets. They are highlypopular on stock indices, interest rates and foreign exchange.A financial futures traded contract is an exchange traded contract for thedelivery of standardized amounts of the underlying financial instrument at afuture date. The price for financial instrument is agreed on the day contract isbought or sold and gains or losses are incurred as a result of subsequent pricefluctuations. Unlike forward contracts, future contracts are readably tradable,reflecting the standardization of contract terms.The purchase or sale of a futures contract is, therefore a commitment to make ortake delivery of a specific financial instrument, at a predetermined price infuture, for which the price is established at the time of initial transaction.Transactions are actually entered into the futures exchange through the open
  12. 12. outcry method on the exchange floor or through screen based tradingsystem.Contracts are standardized which mean the participants can buy and sellfreely on the futures exchange with precise knowledge of the contracts beingtraded. The contract specifies both the type of the financial instrument and itsquality in terms of such matters as coupoun rate and maturity. The instrumentsspecified must be delivered at or during the specific month in future known asdelivery date usually in the cycle of March, June, September and December.Exact delivery details vary according to the nature of investment or indicator.For contracts based on stock market indices, no physical delivery can take placeand settlement is based on cash payment calculated on the movement of theindex.Although contracts are traded between the buyer and the seller on the exchangefloor, each has an obligation not to the other, but to the clearing house. Thisfeature ensures that the future markets are free of credit risk.Participants may offset equal no of bought and sold contracts of the same typeand delivery month and thereby closeout a position without actuallycommunicating the original countertparty.The transaction is simply closeddown once the deal is notified to the clearing house.As the market moves, holders of open futures contract will see correspondingprofits and losses arising out of the positions. The standard nature of each futurecontract makes gains or losses easy to measure. Movements are tracked in termsof minimum price fluctuations allowed by the future exchanges which areknown as “ticks” and which carry a fixed value for each contract type.
  13. 13. 2.2: Terminologies in Futures Market2.2.1: Spot Price: The price at which an underlying asset trades in the spotmarket2.2.2: Futures Price: The price that is agreed upon at the time of the contractfor the delivery of an asset at a specific future date.2. 2.3: Expiry Date: Is the date on which the final settlement of the contracttakes place2.2.4: Basis:Basis is defined as the futures price minus the spot price. Therewill be a different basis for each delivery month for each contract. In a normalmarket, basis will be positive. This reflects that futures prices normally exceedspot prices.2.2.5: Contract Size: The amount of asset that has to be delivered under onecontract. This is also called as the lot size.2.2.6: Contract Cycle: It is the period over which a contract trades. The indexfutures contracts on the NSE have one-month, two-month and three-monthexpiry cycles which expire on the last Thursday of the month. Thus a Januaryexpiration contract expires on the last Thursday of January and a Februaryexpiration contract ceases trading on the last Thursday of February. On theFriday following the last Thursday, a new contract having a three-month expiryis introduced for trading.
  14. 14. 2.2.7: Cost of Carry: Measures the storage cost plus the interest that is paid tofinance the asset less the income earned on the asset.2.2.8: Initial Margin: The amount that must be deposited in the margin accountat the time a futures contract is first entered into is known as initial margin.2.2.9: Marking to Market: In the futures market, at the end of each trading day,the margin account is adjusted to reflect the investor‟s gain or loss dependingupon the futures account is adjusted to reflect the investor‟s gain or lossdepending upon the futures closing price. This is called marking-to market.2.2.10: Maintenance Margin:Investors are required to place margins with theirtrading members before they are allowed to trade. If the balance in the marginaccount falls below the maintenance margin, the investor receives a margin calland is expected to top up the margin account to the initial margin level beforetrading commences on the next day.2.3: TYPES OF FUTURES CONTRACTOn the basis of the underlying asset they derive, the futures are divided into twotypes.Index Futures:Index futures are the futures, which have the underlying asset as an Index. TheIndex futures are also cash settled. The settlement price of the Index futuresshall be the closing value of the underlying index on the expiry date of thecontract
  15. 15. Stock Futures:The stock futures are the futures that have the underlying asset as the individualsecurities. The settlement of the stock futures is of cash settlement and thesettlement price of the future is the closing price of the underlying securityCommodity Futures:The basic concept of a Futures contract remains the same whether theunderlying happens to be a commodity or a financial asset. Due to the bulkynature of the underlying assets, physical settlement in commodity, futures createthe need for warehousing.Currency Futures:When the underlying of Futures is an exchange rate, the contract is termed a“currency futures contract”. In other words, it is a contract to exchange onecurrency for another currency at a specified date and a specified rate in thefuture. Therefore, the buyer and the seller lock themselves into an exchange ratefor a specific value and delivery date. Both parties of the futures contract mustfulfill their obligations on the settlement date2.4: PURPOSE FOR TRADING IN FUTURES MARKET1) Investment:Take a view on the market and buy or sell accordingly
  16. 16. 2) Price Risk Transfer:Hedging is buying and selling futures contracts to offsetthe risks of changing underlying market prices. Thus it helps in reducing therisk associated with exposures in underlying market by taking a counter -positions in the futures market. For example, the hedgers who either havesecurity or plan to have a security is concerned about the movement in the priceof the underlying before they buy or sell the security. Typically he would take ashort position in the Futures markets, as the cash and futures price tend to movein the same direction as they both react to the same supply/demand factors.3) Arbitrage:Since the cash and futures price tend to move in the same directionas they both react to the same supply/demand factors, the difference between theunderlying price and futures price called as basis. Basis is more stable andpredictable than the movement of the prices of the underlying or the Futuresprice. Thus arbitrageur would predict the basis and accordingly take positions inthe cash and future markets.4) Leverage:Since the investor is required to pay a small fraction of the value ofthe total contract as margins, trading in Futures is a leveraged activity since theinvestor is able to control the total value of the contract with a relatively smallamount of margin. Thus the Leverage enables the traders to make a larger profitor loss with a comparatively small amount of capital.Marking to Market:The process of adjusting the amount in an investors marginaccount in order to reflect the change in the settlement price of futures contracton a daily basis is known as Marking to Market.contract and(ii) A short position of a contract, varies with the changes in settlement pricefrom day to day is given below
  17. 17. Profit Opportunities with Futures:With futures, the trader can profit under a number of different circumstances.When the trader initially purchases a futures contract he is said to be “long,” andwill profit when the market moves higher. When a trader initially sells a futurescontract he is said to be “short” and will profit.Going short in a futures market is much easier than going short in othermarkets. Other markets sometimes require the trader to actually own the item heis shorting, while this is not the case with futures. Like most other markets, aprofit is obtained if you initially buy low and later sell high or initially sell highand later buy low.Pay off Futures:Futures contracts have linear payoffs. It means that the losses as well as profitsfor the buyer and the seller of a futures contract are unlimited.Pay off for a Buyer of Futures: Long FutureThe payoff for a person who buys a futures contract is similar to the payoff for aperson who holds an asset. He has a potentially unlimited upside as well as apotentially unlimited downside. Pay-off indicates the amount of profit or lossone may arrive.
  18. 18. EXAMPLE:Take the case of a speculator who buys a two month RELIANCE futurescontract when the reliance stands at 2000. The underlying asset in this case isthe reliance shares. When the reliance moves up, the long futures position startsmaking profits, and when index moves down it starts making losses.ProfitLossThe pay-off for a long position in a futures contract on one unit of an asset is:Long Pay-off = S T – F
  19. 19. 1) Where F is the traded futures price and ST is the spot price of the asset at expiryof the contract (that is, closing price on the expiry date). This is because theholder of the contract is obligated to buy the asset worth ST for F.2) In this case: ST=2500 and F=2000If ST is greater than F, the investor makes a profit and higher the ST, the higheris the profit. It shows the profits for a long futures position. The trader bought 1lot (say 100 futures) when the Reliance spot was trading at 2000. The Reliancespot went up by 500 points. He made a profit of INR 50,000 (2500-2000 * 100).If the index falls, his futures position starts showing losses.Pay off for Seller of Futures: Short FuturesThe payoff for a person who sells a futures contract is similar to the payoff for aperson who shorts an asset. He has a potentially unlimited upside as well as apotentially unlimited downside.EXAMPLETake the case of a speculator who sells a two-month RELIANCE futurescontract when the Reliance stands at 2000. The underlying asset in this case isthe Reliance shares. When the Reliance spot moves down, the short futuresposition starts making profits, and when the index moves up, it starts makinglosses.
  20. 20. 1) The pay-off from a short position in a futures contract on one unit of asset is:Short Pay-off = F – STIn this case: ST=2000 and F =1500. If ST is less than F, the investor makes aprofit and the higher the ST, the lower the profit.2) Above example shows profits for short futures position. The trader short soldfutures when the Reliance spot was trading at 2000. The Reliance spot wentdown by 500 points. He made a profit of INR 50,000. (If 1 lot = 100 futures). Ifthe index rises, his futures position starts showing losses.
  21. 21. 2.5: What is a stock index futures contract?A stock-index futurescontract is a contract to buy or sell the face value of theunderlying stock index, where the face value is defined as being the value ofindex multiplied by a specific monetary amount (called the multiplier)This product makes it possible to equate the value of a stock index with that of aspecific basket of shares having the following specifications.The total value of shares must match the monetary value of the index.The shares selected must correspond to the set of shares used to create theindex.The amount of each holding must be in proportion to the market capitalizationof each of the companies included in the index. The profit or loss from a stock-index futures contract that is settled on the delivery is difference between thevalue of index at delivery date and the value on the date of entering into thecontract. It is important to emphasize that the delivery at settlement date cannotbe underlying stocks of the index, but must be in cash. The futures index atexpiration is set equal to the cash index on that day.
  22. 22. 2.6: Advantages of using Stock-Index Futures1. Actual Purchase of Securities Not Involved: Stock index futures permitinvestment in the stock market without the trouble and expense involvedin buying the individual securities.2. Lower Transaction Costs: The transaction costs are typically 60-75%lower than those for physical share transactions.3. High Leverage Due To Margin System: Operating under a marginingsystem, stock index futures allow full participation in market moveswithout significant commitment of capital. The margin levels allowleverage of between 10 to 40 times.4. Hedging of Share Portfolio: Portfolio managers for large share portfolioscan hedge the value of their investment against adverse price fluctuationswithout having to alter the composition of portfolio periodically.From the following simplified example, it will be clear how to use futures tocover a position exposed to risk of upward movement in the equity markets.Suppose that it is May 1, and an investment manager considers that the marketwill rise prior to August 1 when he is due to receive Rs 5 lakhs to purchase adiversified portfolio of equities. He can get the benefit of investing this sum attoday‟s market level by buying sufficient BSE Sensex futures contract.
  23. 23. On May 1, the September contract (The nearest contract following the targetdate of August 1) is priced at 2000. This means that one contract is worth Rs50,000(i.e. the price of the index is 2, 00, 000 which is 2000 ticks each of isworth Rs 25). Hence the manager needs to purchase 10 contracts (because10*50,000 = Rs 5,00, 000).Let us suppose that equity price do rise and by August 1, the BSE Sensex andthe September futures contract both stand at 2,200 i.e. both have increased by10%. The value of each futures contract has increased by Rs 55,000. Hence the10 contracts are worth Rs 5.5 lakhs.The investment manager can now sell hisfutures contract and realize a Rs 50,000 profit. This added to the Rs 5 lakhsanticipated receipt, leaves him Rs 5.5 lakhs to invest.
  24. 24. CHAPTER 3: FORWARDS3.1: Definition of Forwards contractA forward contract or simply a forward is a contract between two parties to buyor sell an asset at a certain future date for a certain price that is pre-decided onthe date of the contract. The future date is referred to as expiry date and the pre-decided price is referred to as Forward Price. It may be noted that Forwards areprivate contracts and their terms are determined by the parties involved.A forward is thus an agreement between two parties in which one party, thebuyer, enters into an agreement with the other party, the seller that he wouldbuy from the seller an underlying asset on the expiry date at the forward price.Therefore, it is a commitment by both the parties to engage in a transaction at alater date with the price set in advance. This is different from a spot marketcontract, which involves immediate payment and immediate transfer of asset.The party that agrees to buy the asset on a future date is referred to as a longinvestor and is said to have a long position. Similarly the party that agrees tosell the asset in a future date is referred to as a short investor and is said to havea short position. The price agreed upon is called the delivery price or theForward PriceForward contracts are traded only in Over the Counter (OTC) market and not instock exchanges. OTC market is a private market where individuals/institutionscan trade through negotiations on a one to one basis.
  25. 25. 3.2: Settlement of forward contractsWhen a forward contract expires, there are two alternate arrangements possibleto settle the obligation of the parties: physical settlement and cash settlement.Both types of settlements happen on the expiry date and are given below.Physical SettlementA forward contract can be settled by the physical delivery of the underlyingasset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) andthe payment of the agreed forward price by the buyer to the seller on the agreedsettlement date. The following example will help us understand the physicalsettlement process.Consider two parties (A and B) enter into a forward contract on 1 August, 2009where, A agrees to deliver 1000 stocks of Unitech to B, at a price of Rs. 100 pershare, on 29thAugust 2011 (the expiry date). In 100 per share on 29thAugust2011 has a short position and B, who has committed to buy 1000 stocks at Rs.100 per share is said to have a long position.In case of physical settlement, on 29th August, 2011 (expiry date), A has toactually deliver 1000 Unitech shares to B and B has to pay the price (1000 * Rs.100 = Rs. 10,000) to A. In case A does not have 1000 shares to deliver on 29thAugust, 2011, he has to purchase it from the spot market and then deliver thestocks to B.On the expiry date the profit/loss for each party depends on the settlement price,that is, the closing price in the spot market on 29thAugust 2011. The closingprice on any given day is the weighted average price of the underlying during
  26. 26. the last half an hour of trading in that day Depending on the closing price, threedifferent scenarios of profit/loss are possible for eachScenario I: Closing spot price on 29 August, 2011 (S T) is greater than theForward price (FT ). Assume that the closing price of Unitech on the settlementdate 29 August, 2011 is Rs. 105. Since the short investor has sold Unitech at Rs.100 in the Forward market on 1 August, 2011, he can buy 1000 Unitech sharesat Rs. 105 from the market and deliver them to the long investor. Therefore theperson who has a short position makes a loss of (100 – 105) X 1000 = Rs.5000. If the long investor sells the shares in the spot market immediately afterreceiving them, he would make an equivalent profit of (105 – 100 ) X 1000 =Rs. 5000.Scenario II. Closing Spot price on 29 August (S T), 2009 is the same as theForward price (F T). The short seller will buy the stock from the market at Rs.100 and give it to the long investor. As the settlement price is same as theForward price, neither party will gain or lose anythingScenario III. Closing Spot price (ST) on 29 August is less than the futures price(F T) . Assume that the closing price of Unitech on 29 August, 2009 is Rs. 95.The short investor, who has sold Unitech at Rs. 100 in the Forward market on 1August, 2009, will buy the stock from the market at Rs. 95 and deliver it to thelong investor. Therefore the person who has a short position would make aprofit of (100 – 95) X 1000 = Rs. 5000 and the person who ha s long position inthe contract will lose an equivalent amount (Rs. 5000), if he sells the shares inthe spot market immediately after receiving them.The main disadvantage of physical settlement is that it results in huge
  27. 27. transaction costs in terms of actual purchase of securities by the party holding ashort position (in this case A) and transfer of the security to the party in the longposition (in this case B). Further, if the party in the long position is actually notinterested in holding the security, then she will have to incur further transactioncost in disposing off the security. An alternative way of settlement, which helpsin minimizing this cost, is through cash settlementCash SettlementCash settlement does not involve actual delivery or receipt of the security. Eachparty either pays (receives) cash equal to the net loss (profit) arising out of theirrespective position in the contract. So, in case of Scenario I mentioned above,where the spot price at the expiry date (ST) was greater than the forward price(F T), the party with the short position will have to pay an amount equivalent tothe net loss to the party at the long position. In our example, A will simply payRs. 5000 to B on the expiry date. The opposite is the case in Scenario (III),when ST< FT. The long party will be at a loss and have to pay an amountequivalent to the net loss to the short party. In our example, B will have to payRs. 5000 to A on the expiry date. In case of Scenario (II) where ST = FT, thereis no need for any party to pay anything to the other party. The profit and lossposition in case of physical settlement and cash settlement is the same exceptfor the transaction costs which is involved in the physical settlement.
  28. 28. 3.3:Default Risk in Forward ContractA drawback of forward contracts is that they are subject to default risk.Regardless of whether the contract is for physical or cash settlement, thereexists a potential for one party to default, i.e. not honor the contract. It could beeither the buyer or the seller. This results in the other party suffering a loss.This risk of making losses due to any of the two parties defaulting is known ascounter party risk. The main reason behind such risk is the absence of anymediator between the parties, who could have undertaken the task of ensuringthat both the parties fulfill their obligations arising out of the contract. Defaultrisk is also referred to as counter party risk or credit risk3.4: Difference between Forward & Future Contract
  29. 29. CHAPTER 4: OPTIONS4.1: Definition of OptionsOption is a type contract between two persons where one grants the other theright to buy a specific asset at a specific price within a specified time period.Alternatively the contract may grant the other person the right to sell a specificasset at a specific price within a specific time period. . In order to have thisright, the option buyer has to pay the seller of the option premium.Options are an important element of investing in markets, serving a function ofmanaging risk and generating income. Unlike most other types of investmenttoday, options provide a unique set of benefits. Not only does option tradingprovide a cheap and effective means of hedging one‟s portfolio against adverseand unexpected price fluctuations, but it also offers a tremendous speculativedimension to trading.One of the primary advantage of option trading is that the option contractsenable a trade to be leveraged, allowing the trader to control the full value of anasset for a fraction of the actual cost. And since an options price mirrors that ofthe underlying asset at the very least, any favorable return in the asset will bemet with greater percentage return in the option provides limited risk andunlimited reward.With options, the buyer can only lose what was paid for the option contract,
  30. 30. which is the fraction of what the actual cost of the asset would be. However theprofit potential is unlimited because the option holder possesses a contract thatperforms in sync with the asset itself. If the outlook is positive for the security,so too will the outlook be for that assets underlying options. Options alsoprovide their owners with numerous trading alternatives. Options can becustomized and combined with other options and even other investments to takeadvantage of any possible price dislocation within the market. They enable thetrader or them investor to acquire a position that is appropriate for any type ofmarket outlook that he or she may have, be it bullish, bearish, choppy or silent.A derivative security is any security in whole or in part the value of which isbased upon the performance of another underlying instrument, such as option , awarrant or any hybrid securities.Typically, option trading is more cumbersome and complicated than stocktrading because traders consider many variables aside from the direction theybelieve market will move. The effects of the passage of time, variables such asdelta and the underlying market volatility on the price of the option are justsome of the many items that prudent in ones investment decision, one couldpotentially lose a lot of trading options. Those who disregard carefulconsideration and sound money management techniques often find out the hardway that these factors can quickly and easily erode the value of their optionportfolios.
  31. 31. 4.2: Types of OptionsCall OptionA call option gives the holder (buyer/ one who is long call), the right to buyspecified quantity of the underlying asset at the strike price on or beforeexpiration date. The seller (one who is short call) however, has the obligation tosell the underlying asset if the buyer of the call option decides to exercise hisoption to buy.Example: An investor buys One European call option on Infosys at the strikeprice of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on theday of expiry is more than Rs. 3500, the option will be exercisedThe investor will earn profits once the share price crosses Rs. 3600 (Strike Price+ Premium i.e. 3500+100).Suppose stock price is Rs. 3800, the option will be exercised and the investorwill buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it inthe market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) –PremiumIn another scenario, if at the time of expiry stock price falls below Rs. 3500 saysuppose it touches Rs. 3000, the buyer of the call option will choose not toexercise his option. In this case the investor loses the premium (Rs 100), paidwhich should be the profit earned by the seller of the call option. Premium
  32. 32. Put OptionA Put option gives the holder (buyer/ one who is long Put), the right to sellspecified quantity of the underlying asset at the strike price on or before anexpiry date.Example: An investor buys one European Put option on Reliance at the strikeprice of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance, onthe day of expiry is less than Rs. 300, the option can be exercised as it is in themoney.The investors Break-even point is Rs. 275/ (Strike Price - premium paid) i.e.,investor will earn profits if the market falls below 275.Suppose stock price is Rs. 260, the buyer of the Put option immediately buysReliance share in the market @ Rs. 260/- & exercises his option selling theReliance share at Rs 300 to the option writer thus making a net profit of Rs. 15{(Strike price - Spot Price) - Premium paid}.In another scenario, if at the time of expiry, market price of Reliance is Rs 320/-, the buyer of the Put option will choose not to exercise his option to sell as hecan sell in the market at a higher rate. In this case the investor loses thepremium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of theput option.
  33. 33. The Options GameCall Option Put OptionOption buyer oroption holderBuys the right to buy theunderlying asset at thespecified priceBuys the right to sell theunderlying asset at thespecified priceOption seller oroption writerHas the obligation to sellthe underlying asset (to theoption holder) at thespecified priceHas the obligation to buythe underlying asset (fromthe option holder) at thespecified price4.3: Options are different from FuturesFutures are agreements/contracts to buy or sell specified quantity of theunderlying assets at a price agreed upon by the buyer and seller, on or before aspecified time. Both the buyer and seller are obligated to buy/sell the underlyingasset. Futures Contracts have symmetric risk profile for both buyers as well assellers, whereas options have asymmetric risk profile.In options the buyer enjoys the right and not the obligation, to buy or sell theunderlying asset. In case of Options, for a buyer (or holder of the option), thedownside is limited to the premium (option price) he has paid while the profitsmay be unlimited. For a seller or writer of an option, however, the downside is
  34. 34. unlimited while profits are limited to the premium he has received from thebuyer.The futures contracts prices are affected mainly by the prices of the underlyingasset. Prices of options are however, affected by prices of the underlying asset,time remaining for expiry of the contract and volatility of the underlying asset.It costs nothing to enter into a futures contract whereas there is a cost ofentering into an options contract, termed as Premium
  35. 35. 4.4:Option Terminology4.4.1: Underlying - The specific security / asset on which an options contract isbased.4.4.2: Option Premium - This is the price paid by the buyer to the seller toacquire the right to buy or sell.4.4.3: Strike Price or Exercise Price - The strike or exercise price of an optionis the specified/ pre-determined price of the underlying asset at which the samecan be bought or sold if the option buyer exercises his right to buy/ sell on orbefore the expiration day.4.4.4: Expiration date - The date on which the option expires is known asExpiration Date. On Expiration date, either the option is exercised or it expiresworthless.4.4.5: Exercise Date - is the date on which the option is actually exercised. Incase of European Options the exercise date is same as the expiration date whilein case of American Options, the options contract may be exercised any daybetween the purchase of the contract and its expiration date (see European/American Option)4.4.6:Assignment - When the holder of an option exercises his right to buy/ sell,a randomly selected option seller is assigned the obligation to honor theunderlying contract, and this process is termed as Assignment.4.4.7: Open Interest - The total number of options contracts outstanding in themarket at any given point of time.
  36. 36. 4.4.8: Option Holder - is the one who buys an option which can be a call or aput option. He enjoys the right to buy or sell the underlying asset at a specifiedprice on or before specified time. His upside potential is unlimited while lossesare limited to the Premium paid by him to the option writer.4.4.9: Option seller/ writer - Is the one who is obligated to buy (in case of Putoption) or to sell (in case of call option), the underlying asset in case the buyerof the option decides to exercise his option. His profits are limited to thepremium received from the buyer while his downside is unlimited.4.4.10: Option Class - All listed options of a particular type (i.e., call or put) ona particular underlying instrument, e.g., all Sensex Call Options (or) all SensexPut Options4.5: How to start Option Trading?
  37. 37. Before we devote our attention to more sophisticated option applications, it isimportant that we introduce a basic option foundation. While this introductionto options will be descriptive in its scope, its coverage will by no means beexhaustive. The sheer magnitude of option terminology and strategy couldcomprise an entire book on its own, and that is not our primary focus.Therefore, we will only be addressing the items necessary to understandingoption basics and the techniques we will be presenting throughout the book.This simple introduction is tailored to those who are unfamiliar with optionsWhether they apply to stocks, indices, or futures, all options work in the samemanner. Simply stated, an option is a financial instrument that allows the ownerthe right, but not the obligation, to acquire or to sell a predetermined number ofshares of stock or futures contracts in a particular asset at a fixed price on orbefore a specified date. With each option contract, the holder can make any ofthree possible choices: exercise the option and obtain a position in theunderlying asset; trade option, closing out the trader‟s position in the contractby performing an offsetting trade; or let the option expire if the contract lacksvalue at expiration, losing only what was paid for the option..Option contracts are identified using quantity, asset expiration date, strike price,type, and premium. With the exception of the option‟s premium, each of theseitems is standardized upon issuance of a listed option contract. In other words,once an option contract is created, its rights are static; the price that one wouldpay for those rights is not; it is dynamic and determined by market forces.
  38. 38. Seeing as there are many items which make up the definition of an optioncontract, it is important that each be addressed before moving on.The first aspect of an option contract is the option‟s quantity. The number ofshares or contracts that can be obtained upon exercising an exchange-listedoption contract is standardized. Each stock option contract allows the holder ofthat option to control 100 shares of the underlying security while each futuresoption contract can be exercised to obtain one contract in the underlying futurescontractAnother item that identifies the option contract is the asset itself. The assetrefers to the type of investment that can be obtained by the option holder. Thisasset could be a futures contract, shares of stock in a company, or a cashsettlement in the case of an index contractThe type of option is critical in determining the trader‟s market outlook.Unlike trading stocks or futures themselves, option trading is not simply beinglong a particular market or short a particular market. Rather, there are two typesof options, call options and put options, and two sides to each type, long orshort, allowing the trader to take any of four possible positions. One can buy acall, sell a call , buy a put , sell a put or any combination thereof.It is important to understand that trading call options is completely separatefrom trading put options. For every call buyer there is a call seller; while forevery put buyer there is a put seller. Also keep in mind that option buyers haverights, while option sellers have obligations. For this reason, option buyers havea defined level of risk and option sellers have unlimited risk.
  39. 39. A call option is a standardized contract that gives the buyer the right, but not theobligation, to purchase a specific number of shares or contracts of an underlyingsecurity at the option‟s strike prices, or exercise price, sometime before theexpiration date of the contract. Buying a call contract is similar to taking a longposition in the underlying asset, and one would purchase a call option if onebelieved that the market value of the asset was going appreciate before the datethe option expires. The most trader can lose by purchasing a call option issimply the price that he or she pays for the option; the most the trader can makeis unlimitedOn the other side of the transaction, the seller, or writer, of a call options has theobligation, not the right, to sell a specific number of shares or contracts of anasset to the option buyer at the strike price, if the option is exercised prior to itsexpiration date. Selling a call contract acts as a proxy for a short position in theunderlying asset, and one would sell a call option if one expected that themarketvalue of the asset would either decline or move sidewaysThe most an option seller can make on the trade is the price he or she initiallyreceives for the option contract; the most the trader can lose is unlimited. Inorder to offset a long position in a call option contract, one must sell a calloption of the same quantity, type, expiration date, and strike price. Similarly, inorder to offset a short position in a call option contract, one must buy a calloption of the same quantity, type, expiration date, and strike priceLongWith respect to this booklet‟s usage of the word, long describes a position (instock and/or options) in which you have purchased and own that security in
  40. 40. your brokerage account. For example, if you have purchased the right to buy100 shares of a stock, and are holding that right in your account, you are long acall contract. If you have purchased the right to sell 100 shares of a stock, andare holding that right in your account, you are long a put contract. If you havepurchased 1,000 shares of stock and are holding that stock in your brokerageaccount, or elsewhere, you are long 1,000 shares of stock.When you are long an equity option contract: You have the right to exercise that option at any time prior to its expiration. Your potential loss is limited to the amount you paid for the option contract.PAYOFF DIAGRAM Profit diagrams for a Long Call and a Long PutLONG CALLOUTLOOK = BULLISHS = STRIKE PRICEBEP = BREAK-EVEN-POINT = S+DRDR = DEBIT = INITIAL OPTION COST = MAXIMUM LOSSMAXIMUM GAIN = UNLIMITED
  42. 42. ProfitUnderlying assetLossWith respect to this booklet‟s usage of the word, short describes a position inoptions in which you have written a contract (sold one that you did not own). Inreturn, you now have the obligations inherent in the terms of that optioncontract. If the owner exercises the option, you have an obligation to meet. Ifyou have sold the right to buy 100 shares of a stock to someone else, you areshort a call contract. If you have sold the right to sell 100 shares of a stock tosome-one else, you are short a put contract. When you write an option contractyou are, in a sense, creating it. The writer of an option collects and keeps thepremium received from its initial sale.When you are short (i.e., the writer off) an equity option contract:- You can be assigned an exercise notice at any time during the life of theoption contract. All option writers should be aware that assignment priorto expiration is a distinct possibility.-Your potential loss on a short call is theoretically unlimited. For a put, the riskof loss is limited by the fact that the stock cannot fall below zero in price.
  43. 43. Although technically limited, this potential loss could still be quite large if theunderlying stock declines significantly in price.PAYOFF DIAGRAM Profit diagrams for a Short Call and a Short PutSHORT CALLOUTLOOK = BEARISHS = STRIKE PRICEBEP = BREAK-EVEN-POINT = S+CRCR = CREDIT =INITIAL OPTION PAYMENT RECEIVED = MAXIMUM GAINMAXIMUM LOSS = UNLIMITED
  45. 45. A put option is a standardized contract that gives the buyer the right, but not theobligation, to sell a predetermined number of shares or contracts of anunderlying security at the option‟s strike price, or exercise price, sometimebefore the expiration date of the contract.A put contract is similar to taking a short position in the underlying asset, andone could purchase a put option contract if one believed that the market price ofthe asset was going to decline at some point before the date the option expires.The most a trader can lose by purchasing a put option is simply the price that heor she pays for the option; the most the trader can make is unlimited (in reality,it is the full value of the underlying asset which is realized if its price declines tozero).Conversely, the seller, or writer, of a put option has the obligation, not the right,to buy a specific number of shares or contracts of an asset to the option buyer atthe strike price, assuming the option is exercised prior to its expiration date.Selling a put contract acts as a substitute for a long position in the underlyingasset, and a trader would sell a put contract if he or she expected the marketvalue of the asset to either increase or move sideways. Again, the most anoption seller can make on the trade is the price he or she initially receives forthe option contract; the most the seller can lose is unlimited (in reality, the mostone can lose is the full value of the underlying asset which is realized if its pricedeclines to zero.In order to offset a long position in a put option contract, one must sell a putoption of the same quantity, type, expiration date, and strike price. Similarly, inorder to offset a short position in a put option contract, one must buy a putoption of the same quantity, type, expiration date, and strike price.
  46. 46. OpenAn opening transaction is one that adds to, or creates a new tradingposition. It can be either a purchase or a sale. With respect to an optiontransaction, consider both:Opening purchase – a transaction in which the purchaser‟s intention is to createor increase a long position in a given series of options.Opening sale – a transaction in which the seller‟s intention is to create orincrease a short position in a given series of options.CloseA closing transaction is one that reduces or eliminates an existing positionby an appropriate offsetting purchase or sale. With respect to an optiontransaction:Closing purchase – a transaction in which the purchaser‟s intention is to reduceor eliminate a short position in a given series of options. This transaction isfrequently referred to as “covering” a short position.Closing sale – a transaction in which the seller‟s intention is to reduce oreliminate a long position in a given series of options.Note: An investor does not close out a long call position by purchasing a put,or vice versa. A closing transaction for an option involves the purchase or saleof an option con-tract with the same terms, and on any exchange where theoption may be traded. An investor intending to close out an option position mustdo so by the end of trading hours on the option‟s last trading day
  47. 47. .Call buyers want the market price of the underlying security to go higher so theoption will gain in value and they can make money; and call writer want themarket to go sideways or lower so the option will expire worthless and they canmake money.Put buyers want the market price of the underlying security to go lower so theoption can gain in value and they can make money; and put sellers want themarket price to go higher or sideways so the option will expire worthless andthey can make money. Also, option buyers can choose whether they wish toexercise their options; option sellers cannot.The strike price or exercise price is simply the price at which the underlyingsecurity can be obtained or sold if one were to exercise the option.For a call option, the strike price is the price at which the holder can buy thesecurity from the option writer upon exercising the option. For a put option, thestrike price is the price at which the holder can sell the security to the optionwriter upon exercising the option. These option strike prices are standardized,with the strike increments determined by the asset‟s price.Which of the standardized strike prices the trader chooses depends upon his orher investment needs and capital outlay. Obviously, depending upon theprevailing underlying market price, the rights to some option strike prices willcost more than others.Strike prices for futures options contracts are different than those for stockoptions. Much like options on stock, the trader can choose from any of the
  48. 48. standardized futures option strike prices that are issued. However, the strikeprices that are set for the futures options are more contract-specific, contingentupon the market price of the underlying contract, how the future is priced, andhow it tradesThe expiration date refers to the length of time through which the optioncontract and its rights are active. At any time up to and including the expirationdate, the holder of an option is entitled to the contract‟s benefits, which includeexercising the option (taking a position in the underlying asset), trading theoption (closing one‟s position in the contract by trading it away to anotherindividual), or letting it expire worthless (if the contract lacks value atexpiration). While the trader can choose from any of the listed option expirationmonths he or she wishes to purchase (or sell), the trader cannot choose thespecific date the option will expire. This date is standardized and is determinedwhen the option is listed on the exchange on which it is traded. For most optionson equity securities, the final trading day occurs on the third Friday of eachmonth. The actual expiration occurs the following day, the Saturday followingthe third Friday of the month.The expiration date for futures options is more complicated than that for stockoptions and depends upon the contract that is being traded. Some futures optioncontracts expire the Saturday before the third Wednesday of the expirationmonth while others expire the month before the expiration month. Since anoption‟s expiration date depends upon the type of asset that is traded, it isimportant for a trader to know the specific date the contract will expire beforeinvesting in the option.
  49. 49. American Style of optionsAn American style option is the one which can be exercised by the buyeron or before the expiration date, i.e. anytime between the day of purchase of theoption and the day of its expiry.European Style of OptionsThe European kind of option is the one which can be exercised by the buyer onthe expiration day only & not anytime before that.Leverage and RiskOptions can provide leverage. This means an option buyer can pay a relativelysmall premium for market exposure in relation to the contract value (usually100 shares of underlying stock). An investor can see large percentage gainsfrom comparatively small, favorable percentage moves in the underlying index.Leverage also has downside implications. If the underlying stock price does notrise or fall as anticipated during the lifetime of the option, leverage can magnifythe investment‟s percentage loss. Options offer their owners a predetermined,set risk. However, if the owner‟s options expire with no value, this loss can bethe entire amount of the premium paid for the option. An uncovered optionwriter, on the other hand, may face unlimited risk.Moneyness of OptionAn option is said to be at-the-money, when the options strike price isequal to the underlying asset price. This is true for both puts and calls A calloption is said to be in-the-money when the strike price of the option is less thanthe underlying asset price. For example, a Sensex call option with strike of 3900
  50. 50. is in-the-money, when the spot Sensex is at 4100 as the call option has value.The call holder has the right to buy a Sensex at 3900, no matter how much thespot market price has risen. And with the current price at 4100, a profit can bemade by selling Sensex at this higher price.On the other hand, a call option is out-of-the-money when the strike price isgreater than the underlying asset price. Using the earlier example of Sensex calloption, if the Sensex falls to 3700, the call option no longer has positiveexercise value. The call older will not exercise the option to buy Sensex at 3900when the current price is at 3700.Striking the PriceCall Option Put OptionIn-the-money Strike Price less than SpotPrice of underlying assetStrike Price greaterthan Spot Price ofunderlying assetAt-the-money Strike Price equal to SpotPrice of underlying assetStrike Price equal toSpot Price ofunderlying assetOut-of-the-moneyStrike Price greater thanSpot Price of underlyingassetStrike Price less thanSpot Price ofunderlying asset
  51. 51. A put option is in-the-money when the strike price of the option is greater thanthe spot price of the underlying asset. For example, a Sensex put at strike of4400 is in-the-money when the Sensex is at 4100. When this is the case, the putoption has value because the put holder can sell the Sensex at 4400, an amountgreater than the current Sensex of 4100.Likewise, a put option is out-of-the-money when the strike price is less than thespot price of underlying asset. In the above example, the buyer of Sensex putoption wont exercise the option when the spot is at 4800. The put no longer haspositive exercise value.Options are said to be deep in-the-money (or deep out-of-the-money) if theexercise price is at significant variance with the underlying asset price.The amount by which an option, call or put, is in-the-money at any givenmoment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total optionpremium. This does not mean, however, these options can be obtained at nocost. Any amount by which an option‟s total premium exceeds intrinsic value iscalled the time value portion of the premium.It is the time value portion of an option‟s premium that is affected byfluctuations in volatility, interest rates, dividend amounts and the passage oftime. There are other factors that give options value, therefore affecting thepremium at which they are traded. Together, all of these factors determine timevalue.Option Premium = Intrinsic Value + Time Value
  52. 52. 4.6: Factors that affect the value of an option premiumThere are two types of factors that affect the value of the option premium:Quantifiable Factors:Underlying stock price,The strike price of the option,The volatility of the underlying stock,The time to expiration and;The risk free interest rate.Non-Quantifiable Factors:Market participants varying estimates of the underlying assets future volatilityIndividuals varying estimates of future performance of the underlying asset,based on fundamental or technical analysisThe effect of supply & demand- both in the options marketplace and in themarket for the underlying assetThe "depth" of the market for that option - the number of transactions and thecontracts trading volume on any given day.
  53. 53. 4.7: Different pricing models for optionsThe theoretical option pricing models are used by option traders for calculatingthe fair value of an option on the basis of the earlier mentioned influencingfactors. An option pricing model assists the trader in keeping the prices of calls& puts in proper numerical relationship to each other & helping the trader makebids & offer quickly. The two most popular option pricingmodels are:1) Black Scholes Model which assumes that percentage change in the price ofunderlying follows a normal distribution.2) Binomial Model which assumes that percentage change in price of theunderlying follows a binomial distribution.Options Premium is not fixed by the Exchange. The fair value/ theoretical priceof an option can be known with the help of pricing models and then dependingon market conditions the price is determined by competitive bids and offers inthe trading environment.An options premium / price is the sum of Intrinsic value and time value(explained above). If the price of the underlying stock is held constant, theintrinsic value portion of an option premium will remain constant as well.Therefore, any change in the price of the option will be entirely due to a changein the options time value.The time value component of the option premium can change in response to achange in the volatility of the underlying, the time to expiry, interest ratefluctuations, dividend payments and to the immediate effect of supply anddemand for both the underlying and its option.
  54. 54. Covered and Naked CallsA call option position that is covered by an opposite position in the underlyinginstrument (for example shares, commodities etc), is called a covered call.Writing covered calls involves writing call options when the shares that mighthave to be delivered (if option holder exercises his right to buy), are alreadyowned.E.g. A writer writes a call on Reliance and at the same time holds shares ofReliance so that if the call is exercised by the buyer, he can deliver the stock.Covered calls are far less risky than naked calls (where there is no oppositeposition in the underlying), since the worst that can happen is that the investor isrequired to sell shares already owned at below their market value.When a physical delivery uncovered/ naked call is assigned an exercise, thewriter will have to purchase the underlying asset to meet his call obligation andhis loss will be the excess of the purchase price over the exercise price of thecall reduced by the premium received for writing the call.Intrinsic Value of an optionThe intrinsic value of an option is defined as the amount by which an option isin-the-money or the immediate exercise value of the option when the underlyingposition is marked-to-market.For a call option: Intrinsic Value = Spot Price - Strike PriceFor a put option: Intrinsic Value = Strike Price - Spot Price
  55. 55. The intrinsic value of an option must be a positive number or 0. It cannot benegative. For a call option, the strike price must be less than the price of theunderlying asset for the call to have an intrinsic value greater than 0. For a putoption, the strike price must be greater than the underlying asset price for it tohave intrinsic value.Time DecayGenerally, the longer the time remaining until an options expiration, the higherits premium will be. This is because the longer an option‟s lifetime, greater isthe possibility that the underlying share price might move so as to make theoption in-the-money. All other factors affecting an option‟s price remaining thesame, the time value portion of an option‟s premium will decrease (or decay)with the passage of time.Note: This time decay increases rapidly in the last several weeks of an option‟slife. When an option expires in-the-money, it is generally worth only itsintrinsic value.Expiration DayThe expiration date is the last day an option exists. For listed stock options, thisis the Saturday following the third Friday of the expiration month. Please notethat this is the deadline by which brokerage firms must submit exercise noticesto Stock Exchange Clearing; however, the exchanges and brokerage firms haverules and procedures regarding deadlines for an option holder to notify hisbrokerage firm of his intention to exercise. This deadline, or expiration cut-offtime, is generally on the third Friday of the month, before expiration Saturday,
  56. 56. at some time after the close of the market. Please contact your brokerage firmfor specific deadlines. The last day expiring equity options generally trade isalso on the third Friday of the month, before expiration Saturday. If that Fridayis an exchange holiday, the last trading day will be one day earlier, Thursday.ExerciseIf the holder of an American-style option decides to exercise his right to buy (inthe case of a call) or to sell (in the case of a put) the underlying shares of stock,the holder must direct his brokerage firm to submit an exercise notice to StockExchange Clearing. In order to ensure that an option is exercised on a particularday other than expiration, the holder must notify his broker-age firm before itsexercise cut-off time for accepting exercise instructions on that day.Note: Various firms may have their own cut-off times for accepting exerciseinstructions from customers. These cut-off times may be specific for differentclasses of options and different from Stock Exchange Clearing‟s requirements.Cut-off times for exercise at expiration and for exercise at an earlier date maydiffer as well.Once Stock Exchange Clearing has been notified that an option holder wishes toexercise an option, it will assign the exercise notice to a Clearing Member – foran investor, this is generally his brokerage firm – with a customer who haswritten (and not covered) an option contract with the same terms. StockExchange clearing will choose the firm to notify at random from the total poolof such firms. When an exercise is assigned to a firm, the firm must then assignone of its customers who has written (and not covered) that particular option.Assignment to a customer will be made either randomly or on a “first-in first-out” basis, depending on the method used by that firm. You can find out fromyour brokerage firms.
  57. 57. AssignmentThe holder of a long American-style option contract can exercise the option atany time until the option expires. It follows that an option writer may beassigned an exercise notice on a short option position at any time until thatoption expires. If an option writer is short an option that expires in-the-money,assignment on that contract should be expected, call or put. In fact, some optionwriters are assigned on such short contracts when they expire exactly at-the-money. This occurrence is generally not predictable.To avoid assignment on a written option contract on a given day, the positionmust be closed out before that day‟s market close. Once assignment has beenreceived, an investor has absolutely no alternative but to fulfill his obligationsfrom the assignment per the terms of the contract. An option writer cannotdesignate a day when assignments are preferable. There is generally no exerciseor assignment activity on options that expire out-of-the-money. Ownersgenerally let them expire with no value.What’s the Net?When an investor exercises a call option, the net price paid for the underlyingstock on a per share basis will be the sum of the call‟s strike price plus thepremium paid for the call. Likewise, when an investor who has written a callcontract is assigned an exercise notice on that call, the net price received on aper share basis will be the sum of the call‟s strike price plus the premiumreceived from the call‟s initial sale.When an investor exercises a put option, the net price received for the
  58. 58. underlying stock on per share basis will be the sum of the put‟s strike price lessthe premium paid for the put. Likewise, when an investor who has written a putcontract is assigned an exercise notice on that put, the net price paid for theunderlying stock on per share basis will be the sum of the put‟s strike price lessthe premium received from the put‟s initial sale.Early Exercise/ AssignmentFor call contracts, owners might exercise early so that they can take possessionof the underlying stock in order to receive a dividend. Check with yourbrokerage firm and/or tax advisor on the advisability of such an early callexercise. It is therefore extremely important to realize that assignment ofexercise notices can occur early – days or weeks in advance of expiration day.As expiration nears, with a call considerably in-the-money and a sizeabledividend payment approaching, this can be expected. Call writers should beaware of dividend dates, and the possibility of an early assignment.When puts become deep in-the-money, most professional option traders willexercise them before expiration. Therefore, investors with short positions indeep in-the-money puts should be prepared for the possibility of earlyassignment on these contracts.VolatilityVolatility is the tendency of the underlying security‟s market price to fluctuateeither up or down. It reflects a price change‟s magnitude; it does not imply abias toward price movement in one direction or the other. Thus, it is a majorfactor in determining an option‟s premium. The higher the volatility of the
  59. 59. underlying stock, the higher the premium because there is a greater possibilitythat the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stockincrease, and vice versa.4.8: Option GreeksThe price of an Option depends on certain factors like price and volatility of theunderlying, time to expiry etc. The Option Greeks are the tools that measure thesensitivity of the option price to the above-mentioned factors. They are oftenused by professional traders for trading and managing the risk of large positionsin options and stocks. These Option Greeks are:1) Delta: Is the option Greek that measures the estimated change in optionpremium/price for a change in the price of the underlying.2) Gamma: Measures the estimated change in the Delta of an option for a changein the price of the underlying3) Vega: Measures estimated change in the option price for a change in thevolatility of the underlying.4) Theta: Measures the estimated change in the option price for a change in thetime to option expiry.5) Rho: Measures the estimated change in the option price for a change in the riskfree interest rates.
  60. 60. How the Greeks help in hedgingSpreading is a risk-management strategy that employs options as thehedging instrument, rather than stock. Like stock, options have directional risk(deltas). Unlike stock, options carry gamma, Vega, and theta risks as well.Therefore, if a position involves any combination of gamma, vega, and/or thetarisk, this can be reduced or eliminated by adding one or more options positions.Table 1-1 summarizes the possible hedges and their gamma, vega and thetaimpact for each of the six building blocks.Notice that owning option contracts be they puts or calls, means that you areadding positive gamma, positive vega, and negative theta. Being short either ofthese contracts means acquiring negative gamma, negative vega, and positivetheta. This statement points out that as far as these Greeks are concerned, youget a package deal.By owning options, our position responds favorably to stock-price movement(the position gets longer as the stock price increases and gets shorter as thestock price decreases). The position responds positively to increases in impliedvolatility (and negatively to decreases in implied volatility) and will lose valueover time. By being short options, your position responds adversely to stock-price movement (the position gets shorter as the stock price increases and getslonger as the stock price decreases). The position also responds negatively toincreases in implied volatility (and positively to decreases in implied volatility)and will gain value over time as the time premium of the short option decays.
  61. 61. 4.9: Benefits of Option TradingBesides offering flexibility to the buyer in form of right to buy or sell, the majoradvantage of options is their versatility. They can be as conservative or asspeculative as ones investment strategy dictates.Some of the benefits of Options are as under:1) High leverage as by investing small amount of capital (in form of premium),one can take exposure in the underlying asset of much greater value.2) Pre-known maximum risk for an option buyer3) Large profit potential and limited risk for option buyer4) One can protect his equity portfolio from a decline in the market by way ofbuying a protective put wherein one buys puts against an existing stockposition.5) This option position can supply the insurance needed to overcome theuncertainty of the marketplace. Hence, by paying a relatively small premium(compared to the market value of the stock), an investor knows that no matterhow far the stock drops, it can be sold at the strike price of the Put anytime untilthe Put expires.E.g. An investor holding 1 share of Infosys at a market price of Rs 3800/-thinksthat the stock is over-valued and decides to buy a Put option at a strike price ofRs. 3800/- by paying a premium of Rs 200/-If the market price of Infosys comes down to Rs 3000/-, he can still sell it at Rs3800/- by exercising his put option. Thus, by paying premium of Rs 200,hisposition is insured in the underlying stock.
  62. 62. How can you use options for short-term trading?If you anticipate a certain directional movement in the price of a stock, the rightto buy or sell that stock at a predetermined price, for a specific duration oftimecanoffer an attractive investment opportunity. The decision as to what typeof option to buy is dependent on whether your outlook for the respectivesecurity is positive (bullish) or negative (bearish).If your outlook is positive, buying a call option creates the opportunity to sharein the upside potential of a stock without having to risk more than a fraction ofits market value (premium paid).Conversely, if you anticipate downwardmovement, buying a put option will enable you to protect against downside riskwithout limiting profit potential.Purchasing options offer you the ability to position yourself accordingly withyour market expectations in a manner such that you can both profit and protectwith limited risk.Risks of an options buyerThe risk/ loss of an option buyer is limited to the premium that he haspaid.Risks for an Option writerThe risk of an Options Writer is unlimited where his gains are limited tothe Premiums earned. When a physical delivery uncovered call is exercisedupon, the writer will have to purchase the underlying asset and his loss will be
  63. 63. the excess of the purchase price over the exercise price of the call reduced bythe premium received for writing the call.The writer of a put option bears a risk of loss if the value of theunderlying asset declines below the exercise price. The writer of a put bears therisk of a decline in the price of the underlying asset potentially to zero.Option writing is a specialized job which is suitable only for the knowledgeableinvestor who understands the risks, has the financial capacity and has sufficientliquid assets to meet applicable margin requirements. The risk of being anoption writer may be reduced by the purchase of other options on the sameunderlying asset thereby assuming a spread position or by acquiring other typesof hedging positions in the options/ futures and other correlated markets. In theIndian Derivatives market, SEBI has not created any particular category ofoptions writers. Any market participant can write options. However, marginrequirements are stringent for options writers.
  64. 64. CHAPTER 5: CONCLUSIONThis project concludes that derivatives are powerful and innovative productwhich transfer the risk from those who do not want to take it at a price to thosewho are capable of and expert in managing risk. Hedger, Speculator andArbitrageurs are the people who are prepared to deal with the risk.Financial institution are very sensitive to the risk exposer measures so they lookForward to derivatives market and use various innovative products likeForward, Future, Options and Swaps.Indian derivatives market is strongly routed through the stock exchanges andcommodities market derivatives. Future traders deal through the stockexchanges in a standardize manner. NSE India is the Pioneer of derivativesproduct in India.Derivatives are important tools which help in growth of Indian Capital Markets.SEBI on time to time issue various guidelines to all the dealers of derivatives tobring transparency in the working.
  65. 65. .1 AnalysisSurvey Questions1} Education and qualification of investor who investing in derivativemarket?Under Graduate 6Graduate 10Post graduate 23Professional 11
  66. 66. 2} Income range of investor who invest in derivative market ?Income range Number Of ResultBelow 1,50,000 011,50,000 - 3,00,000 093,00,000 – 5,00,000 14Above 5,00,000 16
  67. 67. 3} Why people do not invest in derivative market ?Results Number of resultLack of knowledge and understanding 27Increase speculation 02Risky and highly leveraged 17Counter party risk 04
  68. 68. 4] What is the purpose of investing in derivative market ?Purpose of investment Number of resultHedge their fund 27Risk control 9More stable 1Direct investment without holding &buying asset13
  69. 69. 5} You participate in derivative market as?Participation as Number of resultInvestor 23Speculator 02Broker / Dealer 08Hedger 17
  70. 70. 6} From where you prefer to take advice before investing in derivativemarket ?Advice fromNumber of resultBrokers 15Research analyst 7Websites 2News network 23Others 3
  71. 71. 7} In which of the following would you like to participate ?Participate in Number of resultStock index future 19Stock index option 13Future on individual stock 06Currency future 09Options on individual stock 03
  72. 72. ANNEXURE1) How are derivatives settled in India?Derivative transactions are currently settled in cash.2) Are the risks involved in derivative trading more than trading in the spotmarket?Yes, sometimes the investors can lose huge amounts within a short span of timein derivatives much more than possible losses in the cash market given similarinvested amounts.3) When one make profits will in Future contracts?If you have bought Futures and the price goes up, you will make profits.If you have sold Futures and the price goes down, you will make profits.4) What is the derivatives scenario in India?Derivative instruments are highly traded in India since its inception in June2000 on NSE. If you see the amount of contracts traded in the exchanges it iscontinuously on a uproll from the past.5) What are the things which are important while trading in derivativesIt is very important for individuals to know that derivatives are highlyleveraged instruments, it can also prove highly risky instrument as the losses arealso high in derivatives. So proper research and risk management strategy mustbe adopted before trading in derivative instruments.